While largely out of favor, we are finding Hong Kong-listed Chinese companies that possess the characteristics we typically look for in our investments—high returns on invested capital, strong balance sheets, and attractive dividend yields. Portfolio Managers Jim Harvey and Dilip Badlani run through some names they currently like and talk about why the market is still appealing.

Hong Kong is a market you have visited frequently. What is it about the market that keeps you interested?

Dilip Badlani: Hong Kong is a gateway to China for many foreign investors and a rich financial market for Royce. There are close to a thousand Chinese companies listed on the Hong Kong Stock Exchange (SEHK), and we continue to find a constant stream of new companies coming into the market that meet our quality metrics.

Hong Kong has evolved as an economy. Fifty years ago it was largely centered on manufacturing, but today it is a financial center and service economy that lends itself to companies interested in doing business in China.

So while we do make separate trips to mainland China to do our due diligence on the ground, we typically find ourselves meeting with company management teams in Hong Kong, as that is where their financial headquarters are typically located.

On our most recent trip to Hong Kong we met with approximately 20 companies, zeroing in on those that tend to pay modest dividends, have leadership positions in a specific niche, operate self-sustaining businesses from a capital structure standpoint, and have a high degree of insider ownership.

Jim Harvey: We've been to Hong Kong more than four times over the last two years. We also conduct conference calls with management teams as well as host them in our offices in New York throughout each year.

Dilip grew up in Hong Kong and still has friends and family on the ground, so he knows it quite well.

During our visits we’ll often follow up with companies we've met with before—which was largely the case on this trip—either because we own them or we just continue to have an interest in them. Revisiting companies adds great perspective.

The management teams we've known over the years have been straightforward with us. They are not promotional types. They have a firm grasp on their businesses and the business climate in which they operate.

Over the past few years, we repeatedly heard the message that things were not going great for many of them. On this trip several of the management teams we met with showed more optimism, which was really encouraging.

Dilip: Despite the doom and gloom about China's slowing economy, the country is still growing at a very healthy rate for the second largest economy in the world. There's ample opportunity for companies to grow alongside the economy as well as take share from less efficient players. We just want to be correctly positioned with the companies that will benefit from the new trends that are emerging.

Jim: One compelling reason why we’re attracted to this market is the large number of companies that possess the characteristics we covet at Royce, such as high returns on invested capital (ROIC) and high cap rates.

But the primary reason we are interested in these Hong Kong-listed Chinese companies today is that they are almost universally out of favor among investors. In our view, this provides a great opportunity.

Also, I think when many U.S. investors think about public Chinese companies they recall the headline-grabbing stories a few years back about several unsavory U.S.-listed Chinese companies that basically went bust.

So I think it’s important to note that the companies we meet with are all listed on the Hong Kong Stock Exchange where they face a much higher hurdle in order to be listed relative to, let's say, the Nasdaq or the NYSE in the U.S. So we like this added layer of protection that comes with listing on the SEHK.

What has changed since your last visit in the summer of 2013?

Dilip: A year ago the sentiment on the ground was more negative, and stocks were not reflecting the negative underlying fundamentals. Now things look more like they’ve bottomed out, and stocks are definitely reflecting that. Sentiment is not amazing but it's improving.

I think people were expecting a big stimulus initiative from the Chinese government that never came. Now they've adjusted their cost structures to this new reality.

The new Chinese leadership is very serious about fixing the structural imbalances in the economy, and I don't think that, when there's a downturn, we’ll see any signs of a property market bubble or a reversion to the old ways. There's been a shift towards more internal growth and a crackdown on corruption, and I think we're beginning to see this take effect.

Jim: Many Chinese companies have been facing a sort of perfect storm of slowing demand and ever increasing rents. This has led to margins being squeezed.

The demand side of the equation has been impacted partly because the new Chinese leadership has clamped down on the practice of "gift giving" among government officials. But consumption in general has also been weak.

Soon we’re going to start to anniversary all of these events. Consumers will start buying again as their incomes are still growing and rents will have to adjust. It's not a sustainable situation for retail tenants to surive in an environment where rents keep going up while sales are essentially flat.

We heard several times from management teams that they're expecting rents to stabilize, or at least not go up as much.

Tell us about the companies you've visited, what you are looking for, and what you generally like about the Hong Kong-listed Chinese companies in which you invest.

Jim: Our Hong Kong holdings are very diverse, spanning a range of sectors and industries.

Dilip: The companies we’ve invested in generally have at least five-year track records. We try to find investments with seasoned management teams that we've met with multiple times.

We're sticking to the Royce methodology of trying to find value-oriented stocks. We’re not macro guys, though we are cognizant of sentiment and valuation, so we go where the opportunities are.

We're long-term investors trying to find good companies using the Royce discipline—patience and a long-term investment horizon. Historically, we think that's been a trusted formula for good returns.

We've known Xtep for a little over four years now. It makes fashion-forward sports apparel and footwear. Like everything else that happened in China when things were going well, the industry got ahead of itself; but now there's been a cleansing of inventory in the system.

It's been two years of pain because of too much inventory in the channel—too much optimism built in—and now for the first time in a while it seems like inventory levels have bottomed and sales are starting to pick up.

Through this entire slowdown, Xtep never had to go to the market to issue equity. The company has a stellar balance sheet, it's sitting on a lot of cash, and it's paid a dividend to us every single year we've owned it.

The stock is cheap, trading around 9-10x earnings, and once people realize it's moved from being just a plain vanilla dividend-paying company back to a growth business, we could see the multiple expand. It's pretty impressive what the company's done.

This is a company that was historically just a manufacturer of apparel and footwear for others, and 14 years ago it decided to create its own brand.

Jim: In China, there are five key, recognized Chinese sports footwear brands, and Xtep is one of them. It's pretty much a Chinese-only brand and very well recognized in the country.

This is a prime example of a management team that was open with us when things were not good over the last two years—it described how the channel was stuffed with inventory and product was not moving.

Now management is indicating that it feels things are correcting and inventory levels have adjusted to levels closer to where they should be.

Dilip: Another company that we've owned for a very long time is Pico Far East. This is another case where management really knows what it's doing when it comes to their business.

Pico makes displays for companies when they present at conventions. Upon first look you might think it’s not such a great business, but management keeps a close eye on costs and runs a lean organization.

Jim: The company will typically have three to four years of visibility. The one thing that became more apparent on this visit was that Pico’s business is far from commoditized. Major global brands such as Mercedes Benz, Citibank, Singapore Airlines, etc. trust the company to build signs and displays that accurately portray their brand images.

Dilip: Again, this is a management team that owns a lot of the company. They've been through several downturns such as the Asian financial crisis back in 1997-98 and the global financial crisis in 2008.

So, like us, they are long-term investors who are just trying to ensure that the company is going to be stronger after each cycle and resilient through every downturn.

Jim: Another consumer company we met with is New World Department Store. The company has been around since 1994, is one of the largest branded department stores in China, and has been consistently profitable.

The company's operating income has grown quite nicely over the years, yet the stock keeps going down because there’s been massive multiple compression. New World is just one of many Chinese consumer companies that is not well liked in the market today.

We really like New World's business model, which is very different from the way department stores operate in the U.S. Here, many department stores take huge inventory risks—they have to purchase correctly and be able to sell their products.

The model in China is closer to a consignment model whereby department stores take a piece of the revenues from their tenants, which is also somewhat akin to a REIT structure. This model enables the company to generate significant amounts of cash flow which it has paid out as dividends.

One thing we wanted to gain an understanding of on our most recent trip was how online shopping has been affecting traditional brick-and-mortar retailers. New World operates with what it calls a hybrid online/offline model where customers can take advantage of online promotions and make purchases on the internet and then go pick up their paid items at a nearby store.

New World does this in cooperation with a company called Tencent, which is one of the biggest online companies in China. In partnership with Tencent, New World distributes a co-branded VIP card that gives customers pre-paid functions—they can deposit money onto the card and receive points and credits as they use it.

Dilip: We also own a company called Pacific Online in Hong Kong—a classic case of an orphaned micro-cap. The company was taken public in 2007 by a bank that no longer does sell-side research in Hong Kong. Insiders have been buying shares since the IPO, and the company pays a nice dividend.

Pacific Online is an Internet portal site and operates PConline, PCauto, PCgames, PClady, PCbaby, and PChouse. PConline, which allowed users to share information about buying computers, was its original core business, which has obviously declined a little because consumers are shifting more towards tablets.

However, the company has five other businesses that meet the demands of other consumer markets.

Its U.S.-listed comps trade at multiples at least 3x higher. Management has executed, they've never had to come back to the market to raise cash, and they've always paid a dividend.

It's quite rare to be able to find a fast growing internet business trading at around 10x earnings.

We believe the market will eventually take notice and prescribe the business a much higher multiple. The good thing is management is not being complacent from an operational standpoint.

As they saw the business for PConline slow down, they launched similar portals to help grow the company organically.

Important Disclosure Information

Jim Harvey and Dilip Badlani are portfolio managers of Royce & Associates, LLC, investment adviser to The Royce Funds. In addition to managing Royce International Micro-Cap Fund (RMI), Jim is Portfolio Manager for Royce Heritage Fund (RHF), Royce Micro-Cap Discovery Fund (RDF), and Royce Select Fund II (RS2). He also serves as Assistant Portfolio Manager for Royce Dividend Value Fund (RDV), Royce Global Dividend Value Fund (RGD), and Royce Micro-Cap Trust (RMT). In addition to managing RMI, Dilip serves as Assistant Portfolio Manager for RGD and Royce International Smaller-Companies Fund (RIS). The thoughts and opinions expressed in this piece are solely those of Mr. Harvey and Badlani and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. There can be no assurance that companies that currently pay a dividend will continue to do so in the future.

This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. Please read the prospectus carefully before investing or sending money. Royce International Micro-Cap Fund invests primarily in micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks The Fund may invest a significant portion of its assets in securities of companies headquartered in foreign countries, which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss.

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